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Business Outlook: Why the Earnings Forecast Is Upbeat

With productivity skyrocketing and labor costs plunging, profits will post strong growth in coming quarters now that demand is beginning to turn up

It's earnings season, and as companies roll out their third-quarter reports, investors are sure to take a long, hard look at the results. Profits in the first and second quarters, while down from the previous year, managed to beat expectations, helping the Standard & Poor's 500-stock index to ascend more than 50% from its low point on Mar. 9. Amid ongoing worries about the strength and sustainability of the recovery, which were heightened by the weaker-than-expected jobs report for September, investors want to see if earnings will validate this year's big market run-up.

The signs look good, and last month's employment data are part of the reason. Through the third quarter, businesses continued to slash labor costs at rates not usually seen even in past severe recessions. In fact, for the past six quarters, companies have cut employees' overall hours worked by far more than they have pared output. The result: a striking 2.8% annual rate of growth in productivity, a rare pace during a recession. Productivity gains averaged only 0.8% annually during the previous nine downturns.

Of course, these are not long-run productivity gains: Businesses cannot slash and burn their way to prosperity. However, they can soften the recession's blow to their bottom lines and put themselves in a position to reap the benefits of the recovery as demand picks up. That's what's happening right now, and that's why third-quarter earnings are likely once again to surprise on the upside.

The September payroll numbers showed that overall hours worked in the third quarter fell at a 3% annual rate from the second quarter. If economists are correct in expecting about 3% growth in real gross domestic product for the quarter, then productivity may well post its second consecutive quarterly advance of about 6%. That would mean unit labor costs, or pay adjusted for productivity, are set to plunge for the third quarter in a row. In fact, unit labor costs, which are a key factor in determining profit margins, appear to have posted the largest three-quarter decline since quarterly data began in 1947.

As company reports begin to trickle in, analysts expect third-quarter earnings per share for the S&P 500 companies to decline 24.8% from a year ago, smaller than the losses in each of the three previous quarters, according to the latest survey by Thomson Reuters (TRI). Eight of the 10 major sectors are expected to post drops, with only the financial and consumer discretionary categories showing increases.

However, as in previous quarters, investors will be focused on how companies perform relative to expectations. One key benchmark will be the number of firms that beat current estimates. In the second quarter, 73% of the S&P 500 performed better than expected, a percentage reached in only one other quarter since Thomson Reuters has kept records. Third-quarter reports appear to be on a similar track. So far, there have been 64 negative pre-announcements, or companies saying they will miss their targets, and 42 positive alerts. That ratio of 1.5 is well below the historical average of 2.1. In fact, that low reading matches the ratio at this stage of the stronger-than-expected second quarter.

The earnings punch from recent productivity gains should be especially evident in the Commerce Dept.'s economy-wide roundup of corporate profits, due on Nov. 24. These numbers cover thousands of firms and are seasonally adjusted to allow tracking from quarter to quarter. They show that the upturn in earnings actually began in the first quarter. Profits in both the first and second quarters rose from the previous quarter, even though sales fell in both periods. What is different in the third quarter is that overall demand is now rising amid an ever more favorable cost structure.

As last month's job data showed, the downside of companies' aggressive commitment to productivity and profits will be very slow improvement in the job markets. However, as demand strengthens, solid earnings will help to drive corporate expansion, the foundation of a sustainable recovery.

Cooper is BusinessWeek's senior editor and senior economist and writes the influential Business Outlook column.